Inflation and money supply


Inflation is one of the most important macroeconomic phenomena today.

Globally, inflation peaked in nearly every economy due to supply disruptions with the consumer price index (CPI) at historic highs in the US and UK.

Pakistan also faces the challenge of inflation. Controlling inflation is one of the government’s two main economic priorities along with maintaining a balanced balance of payments.

Therefore, understanding inflation is paramount, especially in the context of Pakistan.

Broadly speaking, there are three main types of inflation, namely demand-driven inflation, cost-driven inflation, and monetary inflation.

Demand-pull inflation occurs when aggregate demand in the economy exceeds aggregate supply. In this process, too many buyers are looking for too few goods. This causes prices to rise.

Generally speaking, this form of inflation is a by-product of economic growth and is generally considered good up to a certain level.

It is also largely reversible. Prices stabilize as supply catches up with demand. Spending reduction policies can be successfully applied in the short term to prevent the economy from overheating.

As supply catches up through corporate profit motives, policy measures are gradually neutralized.

Cost-push inflation occurs when the cost of doing business increases in the form of higher energy prices, higher commodity prices, and rising wages.

Due to rising costs, the overall supply is shrinking, and again, many buyers end up looking for less goods. This again leads to higher prices.

This form of inflation is difficult to reverse because it creates an inflationary spiral. Moreover, this inflation will only subside with an increase in aggregate supply in the economy, which is usually a process that takes time.

In the short term, spending moderation policies are used to deal with this type of inflation, but they rarely have an impact on aggregate supply.

Inflation could decline slightly due to the demand squeeze. Unlike demand-driven inflation, in this case there is very little profit for firms to increase aggregate supply.

The third and most difficult form of inflation occurs when the money supply increases in the economy at a much higher rate than gross domestic product (GDP).

It is irreversible inflation and it is the most difficult to manage. It reduces the value of the currency. Too many banknotes end up chasing too few goods.

In an IMF working paper – “Central Bank Credit to the Government: What Can We Learn from International Practices?” – this issue is discussed in detail.

One of the main conclusions of this paper is that government borrowing from the central bank, which increases the money supply, is the most chronic source of inflation.

This not only puts upward pressure on inflation, but also leads to a depreciation of the exchange rate, giving rise to an inflationary spiral that continues to feed.

It is pointed out that in developed economies there is absolutely no or very little government borrowing from the central bank, while in emerging and developing economies it is a very common practice.

The main reason for this is a low and fluctuating tax base and limited revenue sources for the government.

Let us now examine the empirical data in Pakistan.

For almost 9 to 10 years, the money supply (broad money – M2) has shown a compound annual growth rate (CAGR) of 14% while GDP at current prices has only increased by 9%.

This means that too much money is chasing too few goods and this is the main and most chronic cause of inflation.

In the current scenario, government borrowing from the central bank will be limited. This, at least in theory, bodes well for the economy as it should have a positive impact on inflation as the money supply would remain suppressed.

In addition, it could also have a positive impact on the other most important priority, namely exchange rate stability.

Added to this measure is the improvement in the government’s budgetary performance. The government plans to collect taxes of up to 6 trillion rupees this year, which could reduce the borrowing needs of the central bank.

From now on, the government can resort to borrowing from commercial banks. The negative side effect of this activity would be the crowding out of private sector finance.

Although private sector advances are already subdued, with banks cashing in government securities, a historically lucrative avenue of safe investment, it remains unclear just how much the private sector would face due to the crowding out effect. Overall, the policy of restricting government borrowing from the central bank is anti-inflationary. It is also expected to support a stable exchange rate and these two things are the need of the hour.

The writer is a banker and teaches economics

Published in The Express Tribune, January 31st2022.

Like Business on Facebook, to follow @TribuneBiz on Twitter to stay informed and join the conversation.

About the author